Clougherty Packing Co. v. Comm'r of Internal Revenue
| Decision Date | 20 May 1985 |
| Docket Number | Docket No. 1954-82. |
| Citation | 84 T.C. No. 61,84 T.C. 948 |
| Parties | CLOUGHERTY PACKING COMPANY, Petitioner v. COMMISSIONER OF INTERNAL REVENUE, Respondent |
| Court | U.S. Tax Court |
OPINION TEXT STARTS HERE
Petitioner's wholly owned subsidiary incorporated a wholly owned captive insurance subsidiary (Lombardy). Petitioner negotiated coverage for its workers' compensation insurance liabilities with Fremont, an unrelated insurance carrier. In addition, Fremont negotiated with petitioner to have Lombardy reinsure portions of petitioner's risk which was insured with Fremont. Under this agreement 92 percent of the premiums paid by petitioner to Fremont were ceded to Lombardy. HELD, petitioner failed to shift 92 percent of its risk of loss; therefore, 92 percent of its premiums paid to Fremont is not deductible as an ordinary and necessary business expense for insurance. Carnation Co. v. Commissioner, 71 T.C. 400 (1978), affd. 640 F.2d 1010 (9th Cir. 1981), followed. MARSHALL W. TAYLOR, for the respondent.
BRIAN J. SEERY, for the petitioner.
The Commissioner determined deficiencies in petitioner's Federal income tax for the taxable years ended July 29, 1978, and July 28, 1979, in the amounts of $370,944 and $628,202, respectively. The sole issue for decision is whether petitioner is entitled to deduct, as an ordinary and necessary business expense, the entire amount paid to an unrelated insurance carrier as insurance premiums for workers' compensation coverage where the unrelated carrier reinsures 92 percent of such risk with the wholly owned captive insurance company of petitioner's wholly owned subsidiary and cedes 92 percent of the premiums to the captive.
All of the facts were stipulated. The stipulation of facts and exhibits are incorporated by this reference. Petitioner Clougherty Packing Company was incorporated under the laws of California on December 31, 1945. At the time of filing the petition, its principal place of business was Los Angeles, California. It filed its corporate Federal income tax returns for the taxable years ended July 29, 1978, and July 28, 1979, with the Internal Revenue Service Center in Fresno, California. The returns were not consolidated returns with its subsidiaries.
During the taxable years involved, petitioner owned all of the issued and outstanding stock of Clougherty Packing Company of Arizona which was incorporated under the laws of Arizona on July 26, 1977. Petitioner's Arizona subsidiary, in turn, owned all of the issued and outstanding stock of Lombardy Insurance Corporation (Lombardy). Lombardy was incorporated under the laws of Colorado on November 24, 1976, pursuant to the Colorado Captive Insurance Company Act. During the taxable years involved, Lombardy was a corporation in good standing with the Department of Insurance of the State of Colorado.
Before 1970 and continuing through the taxable years involved, petitioner employed more than 1,000 workers in California which required that petitioner obtain coverage under the California workers' compensation laws. It was engaged in slaughtering and meat processing. and numerous workers' compensation claims were filed against petitioner by its employees. The employees claimed that they contracted brucellosis, an industrial disease connected with meat processing, Section 3700 of the California Labor Code required employers to maintain workers' compensation coverage by one or more insurers authorized to write compensation insurance in California, or to secure from the California Director of Industrial Relations a certificate of consent to self-insure. Prior to 1978, petitioner elected, in part, to be self-insured with respect to workers' compensation coverage and it, therefore, secured a certificate of consent from the California Director of Industrial Relations. Liability in excess of the limited self-insurance was covered by insurance policies with insurers qualified to do business in California. The per claim limit of petitioner's self-insurance and the California insurance carriers who carried the excess over petitioner's self-insurance coverage from July 31, 1971, through July 30, 1977, were as follows:
+-------------------------------------------------------------+
¦ ¦ ¦Coverage by carrier ¦
+-------------+--------------+--------------------------------¦
¦Year ¦Self-insurance¦in excess of self-insurance ¦
+-------------+--------------+--------------------------------¦
¦July 31, 1971¦$35,000 ¦Employers Surplus Lines, Inc.— ¦
+-------------+--------------+--------------------------------¦
¦ ¦ ¦all in excess of $35,000 ¦
+-------------+--------------+--------------------------------¦
¦July 29, 1972¦1 50,000 ¦Reserve Insurance—excess of ¦
+-------------+--------------+--------------------------------¦
¦ ¦ ¦$35,000 up to $50,0002 ¦
+-------------+--------------+--------------------------------¦
¦ ¦50,000 ¦Employers Reinsurance—all in ¦
+-------------+--------------+--------------------------------¦
¦ ¦ ¦excess of $50,000 ¦
+-------------+--------------+--------------------------------¦
¦July 27, 173-¦35,000 ¦Fremont Indemnity Co.— ¦
+-------------+--------------+--------------------------------¦
¦Aug. 2, 1975 ¦ ¦all in excess of $35,000 ¦
+-------------+--------------+--------------------------------¦
¦July 31, 1976¦75,000 ¦American Bankers Ins. Co. of ¦
+-------------+--------------+--------------------------------¦
¦ ¦ ¦Florida—all in excess of $75,000¦
+-------------+--------------+--------------------------------¦
¦July 30, 1977¦100,000 ¦Puritan Insurance Co.— ¦
+-------------+--------------+--------------------------------¦
¦ ¦ ¦all in excess of $100,000 ¦
+-------------------------------------------------------------+
In order to obtain state certification for self-insurance, petitioner was required to deliver securities to the California State Treasurer as security for potential workers' compensation liabilities. The costs of such securities deposited with the California State Treasurer during the fiscal years ended July 31, 1971, through July 30, 1977, were as follows:
+-----------------------+
¦FYE— ¦Amount ¦
+--------------+--------¦
¦July 31, 1971 ¦$638,269¦
+--------------+--------¦
¦July 29, 1972 ¦638,269 ¦
+--------------+--------¦
¦July 27, 1973 ¦638,269 ¦
+--------------+--------¦
¦Aug. 3, 1974 ¦638,269 ¦
+--------------+--------¦
¦Aug. 2, 1975 ¦857,110 ¦
+--------------+--------¦
¦July 31, 1976 ¦857,110 ¦
+--------------+--------¦
¦July 30, 1977 ¦857,110 ¦
+-----------------------+
Earnings from the securities inured to the benefit of petitioner while on deposit with the state.
From January 1974 to October 1976, petitioner maintained its own staff of adjusters to handle claims for workers' compensation. After October 1976, such claims were handled by an independent insurance broker, Frank B. Hall Management Co. (Hall), a nationwide brokerage firm. During 1976, Hall prepared and submitted to petitioner a detailed report entitled ‘Captive Insurance Study for Clougherty Packing Co.‘ The report proposed that petitioner insure its liabilities for workers' compensation directly with its own captive insurance company organized under the laws of Colorado. This proposal was not adopted on advice of petitioner's counsel because of legal and regulatory problems under California law. Rather than establish a direct insurance captive, the management of petitioner decided to establish a Colorado captive to reinsure some of petitioner's risk. The management concluded that a captive insurance arrangement would reduce the cost of its liabilities for workers' compensation coverage by: (1) Increasing investment income above the amount received on the securities deposited with the State Treasurer of California; (2) eliminating the underwriting costs paid to outside insurance carriers; and (3) receiving favorable Federal tax treatment for the captive insurance company subsidiary which treatment is available to all insurance companies.
The Articles of Incorporation for Lombardy were filed in Colorado on November 24, 1976, but business operations did not commence until a later date. Lombardy was capitalized for $1 million, as required by the Colorado Commissioner of Insurance. Colorado statutes required a minimum capitalization of $750,000. On July 27, 1977, the $1 million of capital was fully paid in, from which $750,000 was used to purchase a certificate of deposit in a Colorado bank, jointly held by Lombardy and the Colorado Division of Insurance. During September 1977, Hall proposed to petitioner's management that Lombardy join a reinsurance underwriting group. As of September 1977, Lombardy was not yet operating and the management of petitioner rejected the group reinsurance underwriting proposal.
Petitioner and Fremont Indemnity Company (an unrelated insurer licensed to write workers' compensation insurance in California, hereinafter referred to as ‘Fremont‘) negotiated for a captive insurance program for petitioner.
On October 25, 1977, Fremont offered, in writing, to provide a captive reinsurance program for petitioner, the pertinent terms of which were as follows:
1. The cost to be 5 percent of the annual earned premium, plus premium taxes, bureau fees and non-incidental costs.
2. The ‘Clougherty Captive Company‘ (as Fremont identified it in its offer) would assume the first $100,000 of any risk, with coverage in excess of $100,000 for any risk being furnished by Fremont.
3. All funds were to be remitted to ‘Clougherty's captive‘ monthly, based on remittances by petitioner to Fremont less costs and deficiencies in collateral.
On October 31, 1977, petitioner's attorney accepted Fremont's offer on...
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